During a recent discussion with a former colleague now working as a credit evaluation manager, I learned that their loan book had grown due to increased borrowing from agro-based industries. She mentioned the difficulty of assessing risks in these sectors, especially with added climate uncertainties. This conversation led me to explore how banks can better incorporate climate risk into loan pricing.  

Climate risk is an unavoidable reality for financial institutions. A few years back the  Central Bank of Kenya (CBK) issued guidelines for managing climate-related risks in commercial banks in response to this reality. The Task Force on Climate-related Financial Disclosures (TCFD) also has guidelines that aim to improve how companies and financial institutions report on climate risks, helping investors and lenders understand the financial impacts of climate change. 

From my brief discussion with my former colleague, it appears there's a disconnect between climate risk guidelines and their actual application in loan pricing. 

Banks need to fully align their business and risk strategies with climate goals, such as reducing financed emissions and increasing green finance. Beyond that they must integrate climate risk into loan pricing for effective risk management, financial stability, compliance, and competitive positioning in the banking sector. 

These are some of the approaches that can be used to integrate climate risk in loan pricing: 

1. Risk Assessment Models: Use models to evaluate climate risks related to projects or borrowers, adjusting loan pricing based on potential impacts. 
   
   
2. Climate Risk Premiums: Reflect additional climate risks in loan pricing, with higher rates for high-risk projects or sectors. 
   
   
3. Green Incentives: Offer better terms for green projects, such as lower rates or longer repayment periods. 
   
   
4. Stress Testing: Include climate risk scenarios in stress tests to set appropriate loan terms and provisions.  
   
   
5. Disclosure Requirements: Require borrowers to report on climate risk management and sustainability, using this information to adjust pricing.  
   
   
6. Climate Risk Training: Educate loan officers and risk managers on evaluating climate risks. 
   
   
7. Partnerships and Standards: Follow frameworks like TCFD or Principles for Responsible Banking to integrate climate risk into loan pricing.
    
8. Dynamic Pricing Models: Develop models that adjust based on current climate data and risk assessments. 

By adopting these strategies, banks can better manage climate risks and promote sustainable lending practices, aiding the transition to a low-carbon economy.